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Icelandic Economy Still in Deep Freeze

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“Authorities should not only review the experience of recentyears, but also grapple with the fundamental question of whyIceland’s monetary policy track record has been so dismal, overnearly a century…the Icelandic Krona has depreciated by 99.5%against the Danish Krone since the two currencies were uncoupledin 1920…” –Arnór Sighvatsson, Deputy Governor of the Central Bankof Iceland, 10 January 2012

[Just came down with a nasty cold. Could use some of Riche’s hot chololate with jalapeños or cayenne to clear my sinuses. My head weighs three tons and I am in no shape to carefully review or split the post, begun eons ago. For those of you with ADD or pressed for time, I made headings and highlighted titles of the most important references. Please forgive any repetition or mistakes. Thanks, im]

Every few months, with predictable regularity, the Icelandic Saga and Myth is enthusiastically revived on the METAR board and tiny Iceland’s financial debacle and four-year recovery is held up as a shining example of how things should be managed by other countries after a fiscal fiasco. There were at least ten glowing posts within the last twelve months, including two posts in the last seven days.1) In one of the posts, Iceland’s banking recovery is favorably compared to the ‘horrible’ one in the U.S., in the other, sweet, grey-haired Icelandic President Olafur Ragnar proudly recounts the Saga of Iceland’s virtually painless recovery, omitting the uglier details of Iceland’s failed banks, collapsed currency and near sovereign collapse from which Iceland is slowly recovering. Since neither currencies of Greece, Spain or the U.S. collapsed, direct comparisons cannot, in my view, be made.

Relative to the size of its economy, Iceland’s banking collapse was the biggest banking failure in economic history, so the IMF.[1] It’s perfectly understandable that a politician like Mr. Grimsson wants to present his country’s recovery in the best light. Iceland has been desperately seeking to latch on to another country’s currency, a must, if they want their banks to play in the arena of internationally connected big banks.

There have been a slew of other posts in the past 12 months, adding considerable volume to the Icelandic mythology. Most information trotted out is superficial, often distorted and frequently downright false, whether it is coming from the much revered Mish, who is not above stretching facts to suit his bias, or from EU-hater Murdock’s Wall Street Journal's often yellow tabloid reporting, or from a misleading blog in the Guardian. Based on the Wall Street Journal’s glowing but inaccurate report of Iceland’s phenomenal recovery by “letting its banks fail,” another poster proclaims: “And instead of rushing into the sort of spending cuts that have ravaged Greece and Spain, Iceland delayed austerity”. 2) [Emphasis original poster] WSJ author and poster both blissfully disregard the history of economic and fiscal circumstances of Iceland and of both Greece and Spain, the latter two constrained by a common currency, and whose troubles became apparent two and three years after Iceland’s near sovereign collapse in 2008.

Any reporter who covers Iceland’s banking and currency meltdowns should at least know that by October-November of 2008, Iceland’s currency had lost 40% in value and inflation was up to 20%. It was instant austerity and instant cuts in spending. Imagine if from one day to the next your dollar is only 60¢ worth while all your necessities go up 20%. I call that severe austerity and most Icelanders had no way to anticipate it or prepare for it, probably explaining two years of rioting and social unrest. Greece or Spain had been badgered by the European Commission and the European Central Bank at least since 2010 to make the necessary structural changes to avoid the economic and banking malaise from which they are now suffering.

The same superficial comparison is made by Icelandic Professor Thorolfur Matthiasson in an article in the Guardian and referred to here on the boards 3) where he cheerfully glosses over some of the uglier aspects of the Icelandic banking and currency collapse and, like the WSJ, completely ignores the tremendous differences between tiny Iceland (population 320,000) and the third and fourth largest economies of the Eurozone: Italy, population over 60.8 million with an extremely fractious political system, and Spain, population 47.2 million, consisting of some obstreperous regions that have, like Catalonia, considered secession. Both Euro countries have completely different reasons for their economic doldrums as has been pointed out in the past and both have had a relatively stable reserve currency, the Euro. The U.S. (population over 300 million) also with a relatively stable reserve currency, an internationally intertwined banking system, and money printing press, is in a class all by itself. After having looked at some of the facts of the Icelandic banking and currency collapse, I personally would not want the Icelandic solution applied to U.S. banks, even if it could be done.

Iceland’s Road to Banking and Currency Collapse

Neither the unrealistic view of Iceland’s banking and currency collapse, nor the miraculous recovery without austerity withstand closer scrutiny. First let’s have a look at how Iceland’s banks piled up trouble. At the height of the financial insanity, the assets of the three largest banks (Landesbanki, Kaupthing, Glitnir ) were more than ten (10) times larger than the country’s GDP, leading monetary experts Willem H. Buiter and wife Anne Sibert to conclude “[Iceland’s] banking model was not viable. The fundamental reason was that Iceland was the most extreme example in the world of a very small country, with its own currency, and with an internationally active and internationally exposed financial sector that is very large relative to its GDP and relative to its fiscal capacity.”[2], [3]

It is of interest that both domestic and foreign reports repeatedly warned about the dangers of Iceland’s banking bubble. It went unheeded. Not only was the banking model moribund, the three banks, according to the Economist, charged punitively high interest rates for loans in Islandic Kronurs (ISK). The result was that only about one-fifth, that is only 20% of all loans to Islanders were in their own currency. As the Economist observed: “Ordinary citizens instead borrowed from their banks in cheaper currencies such as yen and Swiss francs to buy even the most modest homes and cars.”[1] An astounding 80% of Icelanders’ borrowings were either in Swiss francs, yen or other foreign currency.

Icelander Jon Danielsson, Ph.D. from Duke University in economics of financial markets, currently a reader at the London School of Economics, assessed the situation in his article “The first casulaty of the crisis: Iceland,” as follows: “In a small economy like Iceland, high interest rates encourage domestic firms and households to borrow in foreign currency; it also attracts carry traders speculating against ‘uncovered interest parity.’ The result was a large foreign-currency inflow. This lead to a sharp exchange rate appreciation that gave Icelanders an illusion of wealth and doubly rewarding the carry traders. The currency inflows also encouraged economic growth and inflation; outcomes that induced the Central Bank to raise interest rates further.

The end result was a bubble caused by the interaction of high domestic interest rates, currency appreciation, and capital inflows. While the stylized facts about currency inflows suggest that they should lead to lower domestic prices, in Iceland the impact was opposite.”[4] [Emphasis mine]

The notion that “Iceland did nothing wrong,” is likewise not supported by facts as reported by international monetary experts Willem Buiter and Anne Sibert. In the 1990s, the country privatized its banks and lifted all restrictions on capital transactions, allowing the banks to gorge themselves on foreign capital until they suffered fatal indigestion after the collapse of Lehman Bros. in 2008. Even if one believes that lifting all restrictions on capital transactions and ignoring risks was a prudent thing to do, some banking procedures leading to the financial debacle and some behaviors of people in power could be categorized as questionable and even fraudulent, as summarized by Anne Sibert: “Investigation of Iceland's meltdown has revealed dodgy* behaviours ranging from neglect to criminal fraud. This column describes how Icelandic banks issued “love letters” to each other – swapping their debt securities and using the other bank’s debt as collateral. This ruse ensnared not just the Icelandic Central Bank, but also the ECB – a fact that has only recently come to light.”[5] [Emphasis mine] *[USAian translation: tricky, not sound, questionable or suspicious]

Another ‘wrongdoing’ (in quotes because some, like Buiter, felt the Brits were unreasonable) caused friction between the British and Dutch on one hand and the Icelanders on the other. The bone of contention was the refusal of Icelandic banks’ foreign branches to honor the deposit guarantees supposedly protecting the savings of British and Dutch citizens, many retirees, who held Icesave accounts: 300,000 British customers held £4.0 billion (about US$9.9 billion), 125,000 Dutch held €1.7 billion (about US$2.3 bilion), and 30,000 Germans held €308 million of ‘insured’ savings. German taxpayers paid Icesave account holders, many of them retirees, their money back and I suspect negotiated behind the scenes with Iceland (the Germans made two movies in Iceland during 2009, one of them an inviting documentary–makes you wonder what the agreements were).

The British went ballistic and, invoking the 2001 Anti-Terrorism, Crime and Security Act, simply froze the UK assets of the Icelandic banks.[3] As a result, the Icelandic payment system was virtually shut down and the transfer of money between Iceland and other countries was nearly impossible. For a discussion on the legality of the Icelandic Depositors' and Investors' Guarantee Fund (Tryggingarsjó›ur) stiffing foreigners but not Islanders, see Siber, “The Icesave dispute.”[6]

Tiny Iceland, population 317,630, GDP US$11.7 billion in 2009,[7] had little choice but to let her banks and currency collapse. It had insufficient reserves to defend its currency and the country lacked a credible lender of last resort to rescue its banks. It had no options and having no options it not a virtue in my opinion. It could not, even if it had wanted to, pull out of its banking and currency crisis with near-zero interest rates and quantitative easing as larger currency areas like the USA were able to do.

How Not to Resolve a Banking Crisis

In their article “ The collapse of Iceland’s banks: the predictable end of a non-viable business model,” Buiter and Sibert list the policy mistakes made: “During the final death throes of Iceland as an international banking nation, a number of policy mistakes were made by the Icelandic authorities, especially by the governor of the Central Bank of Iceland, David Oddsson. The decision of the government to take a 75 percent equity stake in Glitnir (the first bank to die) on September 29 risked turning a bank debt crisis into a sovereign debt crisis. Fortunately, Glitnir went into receivership before its shareholders had time to approve the government takeover. Then, on October 7, the Central Bank of Iceland announced a currency peg for the króna without having the reserves to support. It was one of the shortest-lived currency pegs in history. At the time of writing (28 October 2008) there is no functioning foreign exchange market for the Icelandic króna.”[3]

Jon Danielsson published several publicly available articles on Iceland’s banking disaster, summarized here: All three large banks were put into receivership October 2008. Instead of using the good bank/bad bank model, considered best practices in resolving banking crises and suggested by the helpful Swedes who had used it in 1992, the failing banks, against the advice of many experts, were split along geographic lines in an attempt to separate domestic from foreign operations. It proved impossible as foreign creditors had claims on both types of assets. The Icelandic assets were of low quality and international creditors wrote down their Icelandic exposures, selling them on the secondary market for 4 to 6 cents on the dollar, mostly to “vulture” funds specializing in distressed assets.

Domestic assets were transferred, along with deposits, to new banks at “fair value” – whatever that means. These ‘new’ banks were capitalized by the State. After (re)capitalization, the ‘new’ banks assumed the role of the old banks in the Icelandic banking system with the loans not written off. Two of the three new banks, Kaupthing and Glitnir, passed indirectly into the hands of foreign vulture funds specializing in distressed assets and without much banking experience nor interest in running a banking system. Vulture funds specialize in maximizing the recovery of distressed short-term asset. The Icelandic government retained a share as well as a veto power on the boards of both banks. The international operations of the three ‘old’ banks, however, went through regular bankruptcy proceedings[8] that have no been completed at this time.

As neither a financial nor banking expert, I have difficulty understanding some of the banking shenanigans. The more I learn about banking, the more I realize how little I know about this opaque, murky industry. It also makes me wonder if the bankers or those in charge of supervising them know what they are doing. The government of Iceland took over three banks, (re)capitalized them and then handed two over to foreign Hedge Funds, still completely unregulated. In my simple-minded view, this is rescuing the banks or bailing them out in the worst possible way. Two of three banks, that is 66% of the entire banking industry of Iceland was handed over to foreign “vulture funds,” the term used by Mr. Danielsson in his article. Iceland may not have had much of a choice but to me this type of rescue is even more distasteful than a straight forward bank bailout as happened in the U.S. Perhaps some bankers or financial wizards frequenting this boards could shed some light on this.

Placing People First? - Riots in the Streets and the Collapse of Iceland’s Government

The oft quoted theory that political instability will be avoided if you “place people first” and let the banks fail is not supported by recent Icelandic history. Already in a recession when its currency and banks collapsed, protests by angry citizens started in the fall of 2008 to force the government to step down. On January 20, 2009, several thousand incensed demonstrators marched to the Icelandic building of parliament, banging pots to disrupt the first 2009 session of parliament. This “Kitchenware Revolution” turned violent, resulting in injuries and arrests. Riots continued unabated for several days. Angry youths physically attacked hapless prime minister, Geir Haarde and pelted him with snowballs, eggs, and cans. The riot resulted in the downfall of the Icelandic government. Here are videos of January 20, 2009, http://www.youtube.com/watch?v=vlFMl8klD-Y&feature=relat... and January 21, 2009, http://www.youtube.com/watch?v=VLGenQiDmQw. Mr. Haarde announced his resignation on January 23, 2009, but unrest, demonstrations and riots continued well into 2010. The following video shows members of parliament on the run from an egg and trash throwing mob, October 1, 2010, http://www.youtube.com/watch?v=OFyOdJWt02Y .

Iceland’s demonstrations and riots went on for more than two years. Obviously, “putting people first” and “letting banks fail” did nothing to prevent political unrest, riots or the collapse of government. Could it be that no matter which path is chosen, either “letting banks fail,” if that’s what really happened, or rescuing them by one method or another, the ultimate price in a financial meltdown and its economic consequences is always borne by the people?

Rising from the Ashes

In 2010 tiny Iceland literally rose from the ashes in a matter of weeks after volcano Eyjafjallajökullo (there is a tongue twister for you) spewed earth’s molten innards into the atmosphere. The cleanup after the currency and banking meltdown, however, was not as swift. It is still ongoing.

The immediate macroeconomic shock of currency and banking collapse was brutal for the average citizen and most companies: the Icelandic Kronur lost 40% of its value over the first three quarters of 2008; by October 2008 inflation was approaching 20%; exchange rate linked debt exploded (remember, Icelanders held 80% of their car loans and mortgages in other currencies) causing balance sheets of most companies and many households to further slide out of kilter; unemployment rose to unprecedented heights. The government itself teetered on the brink of bankruptcy as currency reserves had been depleted and by October 2008 were no longer sufficient to cover financial obligations.

IMF and Others to the Rescue

While Iceland’s banks went into receivership/Hedge Fund acquisition, the government requested and received, after some delaying tactics by the UK and Dutch governments, a $2.1 billion loan from the International Monetary Fund (IMF). It was the first developed country to request financial assistance from the IMF in 30 years. Iceland also received a $3 billion loan from Nordic neighbors, Poland, and Russia, adding up to a total borrowed of $5.1 billion (40% of GDP), to serve its external financing needs over the next three years. The Economist reports supplemental promises for funds also from Britain, the Netherlands and Germany, increasing the potential rescue package to $10.2 billion in total – more than half of Iceland’s GDP. At the time of heavy borrowing from the IMF and others, the Icelandic government, to stabilize its currency, put capital controls in place to prevent money from leaving the country. Last time I checked, about six months ago, they had not yet been lifted despite some experts urging the government to do so.

The IMF and the government of Iceland worked out a plan to right currency and banks. The Icelanders with great discipline and a functioning infrastructure (which Greece has never had) made a remarkable recovery and got their finances back under control, resulting in an improved credit rating. The US press painted a glowing picture of an amazing recovery. No consideration was given to the price Iceland has paid and still pays, nor the pain people had to suffer and a substantial number still suffers. Despite Iceland’s low budget deficit, an economic growth rate of 2.2%, an unemployment rate of 6% (that is very high by Icelandic standards), a relatively stable króna, there are still many unresolved problems as the country’s experts are the first to admit.

Belt Tightening and Exodus

The German media (TV as well as Der Spiegel), less sanguine about Iceland’s miraculous rise from the banking ashes than their U.S. counterparts, reported by the end of 2011 there were early signs of recovery, three years after the banking collapse, particularly in the capital of Reykjavik where people are slowly starting to spend their hard-earned Icelandic krónurs (ISK). But all is not rosy. Der Spiegel also reported “signs of quiet desperation” – people living on the ground floor of their house, the second floor unfinished and unusable, consisting merely of a steel skeleton, because they no longer have the money to finish it. These Icelanders are still better off than those who have lost their home, lost their job, lost their standard of living. Rent alone eats up 40% of the monthly income of 11.3% of the population, leaving little money for bare necessities, see Icelandic government statistics.[9] Below is the sad story of a woman whose hopeless situation is typical of more than 10% Icelandic borrowers according to the country’s experts.

“Lisa Björk Ingolfsdottir is one of few who make no secret of their dire straits. Just five years ago, her life seemed perfect. She had a full-time job as a bookkeeper and 9 million krona (about €57,000) in the bank. She borrowed an additional 13 million krona (about €83,000) and bought the ground-floor apartment of a two-story building near the capital. It also boasted a garden that her two daughters could play in. When the credit bubble burst, Ingolfsdottir's lifelong dream was shattered. First she lost her job. "At first," she says, "I was actually happy. I planned to use my free time to go back to school and get my degree." Then her marriage went sour and she divorced. Today, Ingolfsdottir is a single mother living on welfare. The bank owns her apartment again. Although she was still managing to make her payments until six months ago, inflation and taxes had driven her debts up to about 21 million krona. She doesn't even want to know exactly how much she owes now. "There are no jobs for me," she says, "and even if there were, they wouldn't pay enough for me to be able to pay off this mountain of debt," reports Der Spiegel.[10]

The “fairly dismal economic recovery” with reduced prospects for those needing work moved Icelandic Economy professor Brynjar Peturson Young –he has a degree from MIT– to confess to Spiegel in December of 2011: "Nothing is getting better here ... I advise my students to leave the country."[10] Off they go, mainly to Norway and other Scandinavian countries. Over the past three and a half years more than 8,000 Icelanders have left their country. They are mostly young and well-educated, the type of citizen a country does not want to lose. With a total population of about 311,000, about same as St. Louis, MO, this exodus is a worrisome trend Foreign Minister Ossur Skarphedinsson would like to reverse by joining the European Union (EU) as soon as Iceland’s application of July 17, 2008, is granted. Since 2010 Mr. Skarphedinsson has been tenaciously negotiating with Brussels for Iceland's accession to the European Union. His zeal and optimism are remarkable, particularly since recent surveys show that the majority of his compatriots oppose joining the EU at this point.

Recovery according Iceland’s own Experts

Despite the initial Draconian measures, generous welfare measures to help the populace, admirable discipline in tackling problems, and close IMF guidance, Nirvana has not yet been attained. Iceland’s free economy has not allowed it to “recover from almost any setback in a relatively short period of time” as claimed in one of the posts. There are still many problems to be faced and the latest OECD figures I’ve seen are below several Eurozone countries if I remember correctly. Here are the opinions voiced by Icelandic experts during the October 2011 IMF meeting in Reykjavik:

Fridrik Mar Baldursson, Professor of Economics at Reykjavik University, considers unemployment still high, growth anemic, and inflation too high. Three years after the banking and currency meltdown he assesses the handling of the banking crisis and the recovery thus: “It was clear from the outset that an efficient insolvency regime would be needed for Iceland in order to manage widespread insolvency among firms as well as households after the crisis and to quickly place the new banks on a sound footing – to make them into “good banks”. Progress on this front has been slow. This has been a costly failure.

Court decisions on illegality of exchange rate linked loans have created uncertainty about the value of such loans – as well as providing some debt relief. But progress on debt workout of firms has still been excruciatingly slow – delinquent loans are 30% of the loan book of the banks. It took more than two years to change the law on personal insolvency such that households deeply in debt can be provided a fresh start in a similar way as under the US regime, and the execution has progressed very slowly. The consequence – and to some degree the cause – of this has been that the government has to an extent given in to demands for across the board debt reduction – a costly, ineffectual and regressive policy.”[11] (Emphasis mine)

Erindi Finns Oddssonar, Icelandic Chamber of Commerce, looked at the alarming trend of the changes in Iceland’s tax system. Over 100 changes were made over the past three years, all resulting in higher taxes for the citizens and corporation: capital gains tax has doubled, tax on dividends has increased, individual income tax has been raised, a new wealth tax has been imposed, employers payroll tax has been increased by half, corporate tax has been increased. Iceland now has the fourth highest tax to GDP ratio of OECD members.

This is not good for economic recovery and, to some extent, is reflected in economic statistic of more citizens than ever before leaving the country; consumption and investment are at historic lows; fewer businesses are being started each year, and low working hours since 2008, for further details, see his statement.[12] Higher taxes are not surprising. Since the end of 2008, Iceland’s banks forgave loans equivalent to 13% of GDP. It was wonderful debt relief, easing the burden on more than a quarter of the population but somebody has to pay for this government largesse. Higher taxes are the price. In the end the people always pay the price whether they are Icelanders, Greeks, Spaniards or U.S. Americans and it doesn’t seem to make a difference which method of bank rescue is chosen.

Perp Walks

In an astonishing move, possible under Iceland’s constitution, Icelanders went ahead and sued their former prime minister, Geir Haarde, for allowing the banking situation to careen out of control by ignoring early warning signs and not stepping in sooner. Mr. Haarde who was foreign minister in the 1990s and supported privatization of banks and lifting of restrictions, pleaded innocent to all charges. He feels he is being made a scapegoat for bankers who were hiding information from the government, a contention contradicted by a director of one of the banks Investigations are still ongoing.

A Special Prosecutor’s Office was created in 2008 to investigate Iceland’s financial collapse. The following have been charged:

• Charges were brought against former Prime Minister Geir Haarde. He was eventually found guilty of one of four charges, which did not bring a penalty.

• Charges were brought against Lárus Welding, the former CEO of now-defunct Glitnir Bank. Another banker at Glitnir, Guðmundur Hjaltason, was brought up on charges.

• Charges were brought against Kaupþing Bank executives Hreiðar Már Sigurðsson, Sigurður Einarsson, Ólafur Ólafsson and Magnús Guðmundsson. Hreiðar Már and Sigurður were charged for breach of trust and market abuse, and Magnús and Ólafur for being accomplice to both.

• The headquarters of investment firm Arðvis in Kópavogur were raided. Some of the company’s representatives were arrested and then released.

• Many of Iceland’s business leaders remain under scrutiny, including: Jón Ásgeir Jóhannesson and Jóhannes Jónsson, the owners of the Baugur Group retail empire; Lýður Guðmundsson and Ágúst Guðmundsson, the frozen food investors who were in charge of Kaupthing; and Björgólfur Thor Björgólfsson and Björgólfur Guðmundsson, the brewing and shipping executives who owned Landsbanki.[13]

It seems in Iceland those that participate in financial shenanigans do the perp walk and possibly go to prison. In any event, they’ll probably have a criminal record. Let’s see if they convict any bankers. Wouldn’t it be nice if our financial ‘geniuses’ who caused the financial meltdown were held accountable too?

[2] Willem H. Buiter and Anne Sibert, The Icelandic banking crisis and what to do about it: The lender of last resort theory of optimal currency areas, CEPR, October 2008 (PDF), http://www.willembuiter.com/iceland.pdf

Willem H. Buiter, macroeconomist with an international background is one of the world’s experts on monetary and fiscal matters. He now works for Citigroup, Inc., so his articles are no longer as freely available as before. You can access most of his publications at his personal website, scroll down to “Non-Technical Publications” for material that is easier to read, http://www.willembuiter.com/public.htm. His wife, Anne Sibert, is an economic expert on monetary matters. I deem both thorough and reliable sources.